Step Forward with a Missed Opportunity
On 27th April, the European Commission published the long-awaited final draft for a proposal of the EU fiscal framework. This follows the concept document published in November last year and will now have to go through more negotiations. With EU fiscal rules due to be reactivated in January 2024 – following the unprecedented suspension of the Stability and Growth Pact (SGP) to accommodate the exceptional spending needs driven by Covid-19 and more recently the war in Ukraine – it is hard to overstate the importance of this discussion.
Contrary to what many observers had been dreading, the Commission does not propose inconsequential marginal changes but rather a major shift in the conceptual underpinning of the EU fiscal framework. The spirit of the proposal is to simplify the preventive arm of the SGP and increase the structural flexibility embedded in the system, while at the same time strengthening the role of incentives and the effectiveness of the corrective arm. The flagship SGP debt and deficit thresholds of 60% and 3% of GDP are kept – in part in abeyance to the eternal quest of avoiding a re-opening of the EU Treaty at all costs – but their role within the fiscal framework would be significantly altered under the new system.
The key focus variable of fiscal policy become nationally financed net primary expenditure, i.e. expenditure net of discretionary revenue measures, excluding interest expenditure as well as cyclical unemployment expenditure. This is a positive change, as it removes the structural balance benchmarks that are affected by well-known flaws due to their reliance on highly uncertain estimates of output gaps. The path of net expenditure over the medium term will be anchored to debt sustainability, but the latter will be evaluated in a state-contingent way. As a result, the one-size-fits-none rule prescribing that debt in excess of the 60% Maastricht benchmark be slashed by 1/20th of the difference every year would be substituted by a dynamic debt reduction path incorporating an assessment of fiscal risk. This is a welcome move towards a less dogmatic and more risk-management-like approach to the evaluation of fiscal sustainability.
The counterpart of the increased embedded flexibility is that Member States’ fiscal plans will become stricter, and sanctions in the corrective arm will be toughened. National medium-term fiscal and structural plans are central to this new framework, as they will contain the agreed debt reduction path against which fiscal performance will now be assessed. The Commission proposed introducing annual progress reports against such plans – which would strengthen enforcement. At the same time, sanctions are toughened: for Member States with high debt, departures from the agreed path would by default lead to the opening of an Excessive Deficit Procedure, and getting out of the EDP would be more challenging under the proposed new framework.
The SGP flexibility clause – which in the past has been widely used by the Commission to inject leeway into and otherwise very rigid framework – is preserved, but this extra flexibility is now subject to the stricter requirements consistent with the fact that the overall new framework would be more flexible. Member State can get a 3-years extension to their medium term adjustment if they commit to reforms and investments that support common EU priorities including Green, Digital but also Security and Defense.
This new approach to debt reduction – and the significantly increased power and role that it bestows on the Commission – was bound to be politically contentious. EU finance ministers in March asked the Commission to produce a “common methodology […] that is replicable, predictable and transparent” on which to base the debt reduction trajectory. The German government went further, issuing a “non-paper” in which it set out six proposals “to ensure sufficient debt reduction and prevent back-loading”. German Finance Minister Lindner double down with an Op-Ed in the Financial Times on the eve of the publication of the Commission’s revised proposal, in which he strenuously defended a rule-based approach centered around the 3% and 60% targets and called for commonly agreed numerical benchmarks for debt reduction.
The final Commission’s draft receives two of the proposals in the German non-paper in a clear effort at compromise. While not onboarding the German proposal to link the speed of debt reduction to the level of debt and to set a new numerical required adjustment, the Commission has now clarified hat the debt ration must be lower at the end of the plan that at the start – whereas the initial proposal had a vaguer requirement for debt to be “plausibly declining”. Secondly, in the criteria for setting the debt reduction trajectory for Member States with a public debt above 60% of GDP or deficit above 3% of GDP, the Commission argues that national net expenditure growth should remain below medium-term output growth on average over the horizon of the plan. While more moderate than the original German proposal this runs the risk of being pro-cyclical by requesting countries with higher debt loads to reduce the (potentially-growth enhancing) spending more.
It is too early to say whether this will be the final shape of the EU fiscal framework going forward, and the question of whether Member States are ready to accept a stronger and more powerful role for the Commission remains open. But the proposal is a good step forward because it moves beyond the logic of incremental changes that has dominated the past 10 years and proposes a framework with increased structural flexibility and a more risk-based approach to debt management. In exchange for this, sanctions become more automatic, monitoring is stricter, and any extra flexibility can only be accessed based on a commitment to invest in the common EU priorities. While making some concessions to the (much stricter) German position, the latest draft avoids moving to far back in a rules-only direction. At the same time, the Commission could have done more to embed in the framework structural incentives for strategic investments in EU public goods (by means of e.g. a green golden rule or similar device). As uncertainty still looms on whether the Covid-related Next Generation EU initiative can morph into the prototype of a permanent EU-level spending function, this strikes as a missed opportunity.
Silvia Merler, Head of ESG & Policy Research (Algebris Investments)
This document is issued by Algebris (UK) Limited. The information contained herein may not be reproduced, distributed or published by any recipient for any purpose without the prior written consent of Algebris (UK) Limited.
Algebris (UK) Limited is authorised and Regulated in the UK by the Financial Conduct Authority. The information and opinions contained in this document are for background purposes only, do not purport to be full or complete and do not constitute investment advice. Under no circumstances should any part of this document be construed as an offering or solicitation of any offer of any fund managed by Algebris (UK) Limited. Any investment in the products referred to in this document should only be made on the basis of the relevant prospectus. This information does not constitute Investment Research, nor a Research Recommendation. Algebris (UK) Limited is not hereby arranging or agreeing to arrange any transaction in any investment whatsoever or otherwise undertaking any activity requiring authorisation under the Financial Services and Markets Act 2000.
No reliance may be placed for any purpose on the information and opinions contained in this document or their accuracy or completeness. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in this document by any of Algebris (UK) Limited , its members, employees or affiliates and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions.
The distribution of this document may be restricted in certain jurisdictions. The above information is for general guidance only, and it is the responsibility of any person or persons in possession of this document to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. This document is for private circulation to professional investors only.
© 2023 Algebris (UK) Limited. All Rights Reserved. 4th Floor, 1 St James’s Market, SW1Y 4AH.
The information and opinions contained in these recordings are derived from proprietary and non-proprietary sources deemed by to be reliable by Algebris and are not guaranteed as to accuracy or completeness. They may contain ’forward looking’ information that is not purely historical in nature. There is no guarantee that these will come to pass. Reliance upon information on this site and/or the recordings is at the sole discretion of the reader and/or listener. Past performance is not indicative of current or future results. Algebris is not providing any financial, economic, legal, accounting, or tax advice or recommendations in these podcasts.